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A cash out refinance refers to a refinance of an existing mortgage loan. The new mortgage loan is larger than the existing mortgage loan and the borrower (the borrower), receives the difference in cash. Cash-out refinances are a way for homeowners to turn some equity in their homes into cash.
Let’s take an example: If you have a $300,000.00 house, but owe $200,000 on your current mortgage. This means that you have $100,000 equity, which is a fancy way of saying ownership. Let’s suppose you need some extra cash, say $30,000. To get the money, you could cash-out refinance. This would allow you to get a loan totaling $230,000, which includes the $200,000 that you owe on your house and the $30,000 you will take out in cash.
The Costs of a Cash Out Refinance
In that closing costs will be incurred, a cash-out refinance can be similar to a regular mortgage refinance. These costs can run into the hundreds of thousands or even millions of dollars. You will also have to pay interest on the cash you get (in addition to the mortgage amount), which can add thousands of dollars over the term of the loan.
Uses of the Cash
Cash-out refinances typically allow you to use the cash for almost anything, including paying off your credit card debt and taking a vacation. However, there are some uses that are more smart than others.
It may be a good idea to use a cash out refinance to repay high-interest debts such as credit cards. Do the math and make sure you know the total costs. The interest you pay on your credit card is likely to exceed the interest on the new mortgage loan.
This will give you other benefits: Your credit score may be improved by paying down maxed out credit cards. You can also get a tax benefit by moving credit card debt to mortgage debt. In this case, you can deduct the mortgage interest from your taxes.
You might also consider using the money to make home improvements that will increase your home’s worth. It’s important to remember that no matter what purpose you make with the cash, it can be risky. You could lose the house if the loan amount is not repaid.
Restrictions on a Cash-Out Refinance
In certain situations, lenders may not offer cash-out refinances to borrowers. There are some common limitations: You might need to have a minimum credit score (often higher than for a regular refinance), own your home for at most one year, and have a loan–to-value ratio (that is, the mortgage amount divided with the appraised property value) of no less than 85 percent.
You should consider other options, such as a Home Equity Loan (HEL), or a Home Equity Line of Credit (HELOC) because of the high costs of a cash-out refinance. A home equity loan or credit can be taken out from your existing mortgage. A home equity credit is essentially a line credit where your home is the collateral. You can draw money from this credit line whenever you need it, much like a credit card.
The interest rate is usually adjustable. Home equity loans are a loan that you take out on top of your existing mortgage, using your home as collateral. You get the money in one lump sum and can withdraw it at any time you need it. Fixed interest rates
Consider your needs to determine which option is best for you. Do you need the money in one lump sum or in regular monthly payments? A HEL or cash-out refinance is the best option if you do. If not, a HELOC may be a better choice. Do the math. What are the closing costs, fees, and total interest costs? Which one is the most affordable option for you? Cash-out refinances often have lower interest rates than home equity loans and lines of credit. However, closing costs can be higher. Cash-out refinances reset the term of your loan so you might pay more interest long-term.
The Bottom Line about Cash Out Refinance
If you are able to get a great interest rate and know that you can pay the loan back quickly, and have the cash available for worthwhile causes such as home improvement or paying off high-interest debt, a cash-out refinance may be a good option.
Be careful. If you fail to pay the loan off on time and in full, your home could be at risk. You should avoid a cash-out refinance if the interest rate is not better, you are looking to buy a vacation or indulge in shopping, and/or you worry about your ability to repay the larger loan.